Wednesday, March 25, 2009

Hernando de Soto Says Toxic Assets Emerged From a Shadow Economy -

When in doubt, blame the accountants?

Why? As Hernando de Soto points out, there are trillions of dollars of off balance sheet obligations that can not be easily accounted for.

Without a doubt regulators and law makers deserve much of the criticism for allowing this to happen, but at the root is a failure in information systems (and by this I mean accounting and not IT).

Hernando de Soto Says Toxic Assets Emerged From a Shadow Economy -
"These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property."
Now of course, the accountants were only following the law and as such can only be blamed so much. But maybe if FASB or some other accounting group remembered that their ultimate objective should be to reduce information asymmetries and improve management decisions and not rote compliance and tax avoidance, they would have realized that all liabilities and not just traditional debt obligations should be accounted for in a manner that is accessible both internally and externally.

Investors need to know. Managers need to know.

BTW The small excerpt of the WSJ op/ed piece by Hernando de Soto does not do it justice. Read the whole thing. It is very well thought out.

Update: (about 30 minutes after posting this originally). I just heard from an accountant saying that this was at least partially required. To which I will only say that we can still not figure out actual liabilities this far into the process. It is a problem. Maybe one of ignorance, but at some point the presentation has to improve to make the true risk more easily understood.

Update 2: More evidence that accounting needs to get a wake-up call....From the same day's WSJ in an article on stress-testing banks:

" Remember, 19 of the largest financial firms have been asked to submit to stress tests detailing the adequacy of their capital.

Talk about irony. Financial markets are in disarray today because leading firms chose to bury complicated instruments in their books. The results were opaque balance sheets that hid the considerable use of leverage, and proved misleading both to investors and examiners. These same firms are now being required by regulators to use these misshapen accounts to make far-ahead predictions."

Again, the accounting numbers were and are inadequate.

1 comment:

Anonymous said...

Excuse me but exchange traded derivatives are cleared through legitimate well regulate clearing houses according to strict rules and capital requirements. Do not consider all derivative positions evil, flawed or stupid.

There has never been a clearing party failure at the CBOT. True, derviative trades can be dangerous and inappropriate for many instituions, many reasons and for many people but clearing off exchange is entirely different.